Over the last two months, stock-market fluctuations have been extreme. In August, 400-point swings became a common daily occurrence for the Dow Jones Industrial Average. September has also seen its share of volatile days. Since the end of July, one common measure of volatility, standard deviation, has increased by over 130%. For many investors, extreme bouts of volatility can fray the nerves. Stock-market gyrations cause anxiety and stress and lead to emotionally charged investment decisions. But falling markets aren’t uniformly negative—they do create opportunities. Here are two ways to profit from stock-market corrections.
Plunging stock prices inevitably push some of your holdings into the red. With tax-loss harvesting, you can turn the losses into an asset. How? When you harvest losses, you create a tax shelter that can be used to offset future capital gains. But you don’t just want to sell securities and park the proceeds in cash. The key to successful tax-loss harvesting is to realize losses without giving up exposure to the markets or sectors you are selling. The proliferation of exchange-traded funds has greatly simplified investors’ ability to properly harvest losses. According to Bloomberg, there are over 1,100 ETFs listed in the United States—many of which track similar sectors of the market. For example, there are 144 large-cap stock funds and 35 funds tracking the technology industry. The redundancy of ETFs works in your favor for tax-loss harvesting.
Let’s look at a hypothetical example of how you can use ETFs to harvest losses. Assume you own the world’s largest ETF, the SPDR S&P 500 fund, at a $10,000 loss. You can sell the fund, recognize the loss, and reinvest the proceeds in the Vanguard Large-Cap ETF (Symbol: VV). The $10,000 loss can be used to offset realized capital gains this year or in the future while maintaining exposure to large-cap stocks. The SPDR fund and the Vanguard fund are highly correlated, but they track different indices, so they shouldn’t violate the IRS’s wash-sale rule.
Buy Quality at a Discount
Tumbling stock prices often lead to indiscriminate selling. Investors stop distinguishing between good companies and bad companies and cyclicals and noncyclicals. Savvy investors can take advantage of the panic selling and buy quality companies at discount prices.
We saw indiscriminate selling in the utilities sector when stocks first started to trade down this summer. From July 21 to August 8, the S&P 500 Utilities index plunged almost 12% as the broader market fell 17%. Why did utilities suffer such a steep loss? Was it the slowing global economy or the escalating euro-area debt crisis? Utilities aren’t sensitive to the business cycle, and few would be impacted by developments in Europe. Investors were likely selling utilities stocks along with the rest of the market even though the move in utilities wasn’t justified by the fundamentals. Those who spotted the opportunity were able to buy utilities stocks at their best yields in over two years. When indiscriminate selling ensues, buy quality.
Jeremy Jones, CFA
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